Question

Jill Harrington, a manager at Jennings Company, is considering several potential capital investment projects. Data on these projects follow: Initial investment Annual cash inflows PV of cash inflows Project X $40,000 25,000 45,000 Project Y Project Z $20,000 $50,000 10,000 25,400 33,000 70,000 Required: 1. Compute the payback period for each project and rank order them based on this criterion. (Round your answers to 2 decimal places.) Payback Rank Period Project X Project Y Project Z 2. Compute the NPV of each project and rank order them based on this criterion. NPV Rank 1 Project X Project Y Project Z 3. Compute the profitability index of each project and rank order them based on this criterion. (Round your answers to 2 decimal places.) PL Rank Project X Project Y Project Z 4. If Jennings has limited funds to invest, which ranking should Jill recommend? NPV Ranking Profitability Index Ranking Payback Ranking

Answer 1

Solution

Jennings Company

	Payback Period	Ranking
Project X	1.6 years	I
Project Y	2 years	III
Project Z	1.97 years	II

Project X would be able to fully recover the initial investment in lesser period (1.6 years) compared to the other two projects. Hence, it is ranked the first.

Project Z needs 1.97 years to fully recover the initial investment in terms of annual cash inflows, while Project Y needs 2 years. Hence, the projects are ranked second and third, respectively.

1. Computation of payback period for each project and raking:

Payback period = initial investment/annual cash inflows

Project X –

Initial investment = $40,000

Annual cash inflows = $25,000

Payback period = 40,000/25,000 = 1.6 years

Project Y –

Initial investment = $20,000

Annual cash inflows = $10,000

Payback period = 20,000/10,000 = 2 years

Project Z –

Initial investment = $50,000

Annual cash inflows = $25,400

Payback period = 50,000/25,400 = 1.97 years

2. Computation of the NPV of each project and ranking:

	NPV	Ranking
Project X	$5,000	III
Project Y	$13,000	II
Project Z	$20,000	I

Computations:

NPV – Net Present Value = present value of cash inflows – present value of cash outflows

Project X –

Present value of cash inflows = $45,000

Present value of cash outflows = $40,000

NPV = 45,000 – 40,000 = $5,000

Hence, NPV of Project X = $5,000

Project Y –

Present value of cash inflows = $33,000

Present value of cash outflows = $20,000

NPV = $33,000 - $20,000 = $13,000

Hence, NPV of Project Y = $13,000

Project Z -

Present value of cash inflows = $70,000

Present value of cash outflows = $50,000

NPV = 70,000 – 50,000 = $20,000

Hence, NPV of Project Z = $20,000

3. Computation of the profitability index and ranking:

	Profitability Index	Ranking
Project X	1.125	III
Project Y	1.65	I
Project Z	1.40	II

Computations:

Profitability index = present value of cash inflows/ initial investment

Project X –

Present value of cash flows = $45,000

Initial investment = $40,000

Profitability Index = 45,000/40,000 = 1.125

Project Y –

Present value of cash flows = $33,000

Initial investment = $20,000

Profitability Index = 33,000/20,000 = 1.65

Project Z –

Present value of cash flows = $70,000

Initial investment = $50,000

Profitability Index = 70,000/50,000 = 1.40

4. Limited funds to invest, the recommended ranking –

When a company has limited funds to invest, the primary focus would be on fast recovering the initial investment so as to undertake other projects. Hence, Jill should recommend projects based on payback period criteria. As per the payback period criteria, the project to invest funds would be Project X. With a relatively less payback period of 1.6 years, Project X would fast recover the initial investment so as to be able invest in next projects.